A rate increase and a rising market – but was it really dovish?
Having primed markets to fully expect a US rate increase, the FOMC followed through on the 15th March. If the aim was to deliver a rate increase without abruptly causing tighter financial conditions (code for declining equity and credit markets), then it was mission accomplished. Following the FOMC announcement the dollar eased against other currencies, bond yields fell and equity markets gained. However, despite comforting language within the statement we detected a more strategic, rather than data dependent, direction for US interest rates in the press conference Q&A.
The first point of interest was Yellen’s frequent reference to the appropriate real interest rate when setting monetary policy. During the press conference she confirmed that in the long-run the FOMC expected this rate to be 1%, consistent with its current expectations for 3% interest rates at the end of 2019 and 2% inflation. She also highlighted some estimates which suggest this neutral real rate is currently close to 0%. Therefore, a gradual tightening of interest rates in the region of 75bps per annum between now and late 2019 would certainly fit her thoughts on this matter.
Second, while the statement was widely seen as more dovish than expected, during the press conference a journalist challenged Yellen by observing that, for example the Atlanta Fed’s nowcast model for GDP had fallen to 0.9% for the quarter, yet the Fed was increasing interest rates.
Here the response was not so dovish; Yellen indicated that quarter-to-quarter GDP was “noisy” and should be viewed in a longer-term context. Furthermore, there seemed some reluctance to shift focus away from low unemployment and signs of improving wage growth in her reply. Even if she later confirmed that Fed policy remains data-dependent, her answer may indicate the Fed currently has a bias to gradually tighten policy, on its stated dot-plot trajectory, unless incoming data is sufficiently adverse to meaningfully affect the lagging economic variables of employment and inflation.
Overnight we also take note of the People’s Bank of China raising interbank borrowing costs by 10bps, which is the third increase since the start of 2017. This highlights not only the interconnectedness of the global financial system with respect to the US dollar funding costs but also the shift to tighter monetary policy in China over the coming year, in contrast to the significant easing which benefited markets in 2016, Exhibit 1.
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